Summary

In the 1990s, successive Japanese cabinets attacked the domestic
economy's ills using a tried-and-true approach: compensate for
flagging private-sector demand by expanding budgets for public works
projects and implementing targeted tax breaks. Politicians believed
that pump-priming was effective both economically and politically
 not-insignificant considerations during a decade of discontent
 and so fiscal stimulus was their tonic of choice.

As the final decade of the 20th century unfolded, however, it
became increasingly apparent that the large sums of money being
thrown into public works were not producing the desired macroeconomic
result. Growth remained anemic despite a string of record-setting
stimulus packages. Chastened by this experience and envious of the
booming U.S. economy, political, bureaucratic, business and academic
leaders grudgingly realized that Japan's corporate, financial and
regulatory structures needed to be reformed and updated so that new
industries and economic activities could take root and thrive.

This epiphany, however, by no means relegated fiscal policy to the
dust bin. As Japan entered the new century, the cumulative effects of
Tokyo's decade-long spending spree coupled with restructuring and
deregulation began to show results in the form of positive  if
hesitant  economic growth. The government's spending and tax
plans for FY 2000 were crafted to at least maintain the momentum of
public works spending established the previous year.

Although it is not yet certain that the economy is back on a sure
growth track, the debate already is shifting to address the
ballooning national debt created by a decade of pump-priming. The
impending elections for the Diet lower house make it an impolitic
time to propose new or increased taxes. Nevertheless, tax policy is
coming to the forefront as a two-pronged tool to boost economic
activity while also holding down the debt. Wary of repeating the
April 1997 mistake of raising taxes before solid growth was
established, a decision that pushed the economy back into recession
and contributed to the downfall of a prime minister, policymakers are
considering very carefully their near-term as well as long-range
options.

Overdosed On Fiscal
Stimulus

Between August 1992 and December 1999, Tokyo unveiled 14 economic
stimulus packages worth, by the government's calculations,
¥125.4 trillion ($1.1 trillion at ¥110=$1.00) in added
final demand (see Table 1). Stimulative spending had the lead
role in 10 of these packages, with tax cuts costarring in three. Two
were aimed at resolving the banking industry's nonperforming-loan
crisis, and the remaining two were composed of deregulatory and other
measures for which a monetary value was not given.

Table 1:
Economic Stimulus Packages, FY 1990-FY 1999

(in trillions of yen)

Date

Value

August 1992

¥10.7

April 1993

13.2

September 1993

6.0

February 1994

15.3

April 1995

4.8

September 1995

14.2

October 1997

*

December 1997

2.0**

February 1998

*

April 1998

16.7

October 1998

***

November 1998

23.9

July 1999

0.542

December 1999

18.1

Total

125.4

*No exact value given for proposed
deregulatory and other measures.
**Bank recapitalization plan worth up to ¥30 trillion
also announced.
***Bank restructuring and recapitalization plans worth 43
trillion announced (replaced December 1997 plan).

Source: Ministry of Finance

FY 1999's two packages each had notable points. Although a value
of just ¥542 billion ($4.9 billion) was attached to the July
measure, it went down in history as the first stimulus package to
contain direct government action to counter unemployment, with money
earmarked for local authorities to create jobs for displaced workers,
particularly middle-aged workers targeted by corporate downsizing
efforts (see JEI Report
No. 23B, June 18, 1999). Previous efforts at employment
promotion had been in the form of tax breaks or indirect subsidies to
employers. The December stimulus plan broke with tradition by relying
on new issues of bonds for almost all its funding. While borrowing
had been a central feature of earlier plans, it usually had been
coupled with spending cuts and tax changes.

An injection of ¥125.4 trillion ($1.1 trillion) into the
economy over seven years and four months might have been expected to
kick growth into high gear. A comparison of the announced value of
the economic stimulus plans with the supplementary budgets backing
them up makes it clear that Tokyo expected its pump-priming to ripple
through the economy with great effect. When the supplemental budgets
from FY 1990 through FY 1999 are summed (see Table 2), the grand
total comes to just over ¥36.7 trillion ($333.6 billion), or a
little more than a quarter of the total value of the announced
stimulus plans.

*Primarily to fund Japan's contribution
to the allied Persian Gulf War effort.
**Authorization for government bond guarantees related to
the restructuring and the recapitalization of Japan's
banking industry that was not an actual expenditure.

Source: Ministry of Finance

Domestic and foreign critics of Japan's fiscal policy seized on
the large gap between the announced impact of stimulus packages and
the supplemental budgets as evidence that Japanese political and
bureaucratic leaders were trying to talk up the economy in order to
avoid tough choices on deregulation and restructuring. According to
these analysts, Tokyo's fiscal initiatives were flawed for three
reasons:

The measures were not truly stimulative because they were too
small or did not yield a net increase in public-sector outlays.
Given a nominal gross domestic product that has ranged between
¥475 trillion and ¥500 trillion ($4.3 trillion to $4.5
trillion), even the record-setting ¥23.9 trillion ($217.3
billion) November 1998 package looks like small change. Since the
implementing supplemental budgets are worth only a fraction of the
packages' announced values, the cabinet's actions seemed not to
support its words.

More important from the critics' standpoint was the fact that most
of the supplemental budgets were not financed mainly by borrowing.
Having to find money for the extra budgets by cutting spending in
other areas or raising taxes counteracted their stimulative
strength. The first and second supplemental budgets for FY 1999
illustrate this argument. The ¥519.8 billion ($4.7 billion)
July 1999 spending addendum was paid for by drawing ¥150
billion ($1.4 billion) from reserves and using ¥373.7 billion
($3.4 billion) left over from FY 1998 (see Table 3). The lack
of new borrowing meant no net increase in the public sector from a
macro viewpoint.

Table 3: First FY 1999 Supplemental
Budget, July 8, 1999

(in billions of yen)

Expenditures

Increases

Emergency Employment Measures

¥519.8

--- Job Creation by Venture Business

90.0

--- Reemployment of Middle-Aged,--- Downsized Workers

18.2

--- Temporary Government Jobs

204.7

--- Countermeasures for Aging Society--- and Declining Birth Rate

200.3

--- Promoting Employment of Senior--- Citizens

4.1

--- Social Infrastructure Investment

2.5

Decreases

Reserves

-150.0

Net Change in Expenditures

369.8

Revenues

Nontax Revenues

-3.9

Carryover Surplus from FY 1998

373.7

Net Change in Revenues

369.8

Source: Ministry of Finance

The December 1999 package did count on nearly ¥1.4 trillion
($12.7 billion) in spending cuts to help balance the books but
also included borrowing borrowing almost ¥7.6 trillion ($69.1
billion) in new authority and ¥1.5 trillion ($13.6 billion)
in reduced revenue estimates (see Table 4). Only ¥727
billion ($6.6 billion) of the total expected increase in revenues
of ¥8.3 trillion ($75.5 billion) came from nonbond sources.
True believers in fiscal stimulus lauded the second FY 1999
supplementary budget as an example of what Tokyo should have been
doing all along.

Table 4: Second FY 1999 Supplemental
Budget, November 25, 1999

(in billions of yen)

Expenditures

Increases

Social Infrastructure Investment

¥3,500.0

--- Telecommunications, Science and--- Technology

907.6

--- Social Welfare, Medical Care,--- Education and Environment

546.6

--- Distribution System and Industrial--- Competitiveness

401.7

--- Promotion of Private Investment--- through Urban Redevelopment

609.9

--- Disaster Prevention

517.3

--- Disaster Reconstruction

516.8

Credit and Loan Programs

773.3

Housing Loan Aid

200.1

Employment Assistance

191.7

Financial System Stabilization

927.9

Public Nursing Care Implementation

911.0

Additional Mandatory Outlays

765.0

Housing and Urban Development
Corp.

117.7

Transfer to Welfare Insurance
Account

418.3

Miscellaneous

334.5

Subtotal

8,139.6

Decreases

Reduction in Outlays

-911.9

Transfers to Local Governments

-438.7

Subtotal

-1,350.6

Net Change in Expenditures

6,789.0

Revenues

Increases

Tax Revenues

63.0

Other Revenues

79.1

Bond Issues

7,566.0

--- Construction

3,826.0

--- General Revenue

3,740.0

Carryover Surplus from FY 1998

584.9

Subtotal

8,293.0

Decreases

Tax and Stamp Revenues

-1,504.0

Other Revenues

-0.0

Subtotal

-1,504.0

Net Change in Revenues

6,789.0

Source: Ministry of Finance

The principal conduit for economic stimulus in Japan has been
public works spending, a fact that was welcomed in the decades
during which the war-torn country was rebuilding and catching up
with the West. As Japan's economy has matured, however, economists
have raised doubts about the efficacy of this type of government
expenditure and public interest groups have demonized its
pork-barrel aspects. Critics charge that such traditional
construction projects as bridges, roads, harbors and airports no
longer generate as much of an increase in private-sector activity
for as long as government planners hope. In addition to this
reduction of the multiplier effect, economists argue that
traditional public works do not help prepare the economy for
contemporary competition.

While citizens sympathize with construction workers who depend on
government contracts during hard times, they do not hesitate to
complain when projects are impractical, wasteful or redundant. In
addition, taxpayers are becoming more concerned about the
environmental aspects of major construction projects and
increasingly are willing to question bureaucrats' wisdom and
corporate interests on such issues.

Tokyo resorted to economic stimulus plans so frequently that
they lost potency. As package followed package, even as the
economy continued to stagnate, their novelty and psychological
impact waned. Tokyo's constant trumpeting of stimulus initiatives
was compared to the boy who cried "Wolf!" Another analogy likened
the constant infusions of extra spending to a drug habit: the
addicted economy had become tolerant of the steady stimulus,
required greater doses of spending to elicit a response and feared
a sudden withdrawal of the infusions.

In sum, after 10 years of almost constant invocation with few
lasting results, fiscal stimulus has lost its appeal. Yet advocates
of government spending, including Clinton administration officials,
argue that Tokyo has not executed the policy correctly or with enough
magnitude.

Just as insistent are those on the other side of the debate who
are concerned about the long-term impact of a decade's worth of
pump-priming on the government's outstanding debts and fiscal
balance. With the proportion of citizens over 65 growing quickly
 implying rising social welfare needs  and the country's
birthrate well below the replacement rate  meaning fewer active
workers in the tax base  the government could face a fiscal
Armageddon in a few decades.

The FY 2000 Budget

The compilation of the general account budget for FY 2000 may have
marked a turning point in the fiscal policy debate. Determined to
give the economy one last push, Tokyo devised a fiscal blueprint for
the fiscal year that began April 1 that is the largest initial
general account spending plan in postwar history. With a total of
just under ¥85 trillion ($772.7 billion), it is 3.8 percent
larger than the initial budget for the previous fiscal year.
Government forecasters believe that the current plan will ensure that
the economy attains the government's target of 1 percent real growth
in FY 2000.

The FY 2000 initial spending and tax plans generally resemble
their many predecessors but do contain novel elements. Some observers
praise the Obuchi cabinet's so-called Millennium Projects initiative
as a new paradigm of public works. The government has earmarked
¥11.9 billion ($108.2 million) to bring high technology into
Japan's classrooms, ¥15.2 billion ($138.2 million) to promote
information technologies and ¥64 billion ($581.8 million) to
decode the human genome and that of the rice plant. Critics say,
however, that these exemplary projects represent only a tiny slice of
the public works pie. They point to the 11 percent increase to
¥35.2 billion ($320 million) that Tokyo wants to put into
building new Shinkansen (bullet train) lines as evidence that
wasteful pork-barrel spending continues.

General Account Expenditures

Although not as large as the 5.8 percent increase recorded in the
initial general account budget for FY 1996 or FY 1999's 5.4 percent
mark, the proposed 3.8 percent hike for FY 2000 still is considered a
strong statement of government support for a stimulative fiscal
policy. However, when nondiscretionary items  national
debt-service costs and revenue transfers to local governments 
are subtracted, the stimulative strength of the initial FY 2000
budget is diminished significantly. At 2.6 percent, the gain in
discretionary spending is just half that of the previous fiscal year
(see Table 5). FY 2000's smaller rise in the total budget
combined with its faster growth of nondiscretionary spending creates
the divergence between discretionary outlays in the two fiscal years.

Table 5: General Account Spending (Initial), FY
1996-FY 2000

(in billions of yen and percent change)

FY 1996

FY 1997

FY 1998

FY 1999

FY 2000

Total Expenditures

¥75,104.9

¥77,390.0

¥77,669.2

¥81,860.1

¥84,987.1

5.8%

3.0%

0.4%

5.4%

3.8%

Minus

Debt Service and Transfersto Local Governments

29,979.0

32,283.3

33,133.0

34,972.3*

36,895.6

13.4%

7.7%

2.6%

5.6%

5.5%

Equals

Discretionary Spending

45,125.9

45,106.7

44,536.2

46,887.8

48,091.4

1.3%

-0.0%

-1.3%

5.3%

2.6%

*Includes funds to cover carryover
deficit from FY 1997. Exclusive of these funds, the total
for nondiscretionary items would be ¥33,354.9 billion
and the change 0.7 percent.

Source: Ministry of Finance

A review of spending initiatives by purpose highlights the
stimulative cast of the FY 2000 budget (see Table 6):

Table 6: Summary of Initial General Account
Outlays,
FY 1999-FY 2000

(in billions of yen)

Initial
FY 1999

Change

Initial
FY 2000

Change

Discretionary Items

Human Services

¥16,112.3

8.6%

¥16,766.6

4.1%

Education and Science

6,463.2

1.9

6,522.2

0.9

Pensions

1,478.3

-3.4

1,424.6

-3.6

Defense

4,932.2

-0.2

4,935.8

0.1

Economic Cooperation

987.7

0.8

984.2

-0.4

Public Works

9,430.7

5.0

9,430.7

0.0

Special Targeted Spending Brackets

500.0

n.a.

500.0

0.0

Small Business Measures

192.3

3.5

194.3

1.0

Food Control Programs

268.7

-0.1

223.9

-16.7

Energy Measures

653.1

-2.3

635.1

-2.8

Administration and Operations

5,359.6

1.5

5,963.4

11.3

Transfer to Industrial Investment Special
Account

159.5

0.0

159.5

0.0

Reserves

350.0

0.0

350.0

0.0

aaa Subtotal

46,887.8

5.3

48,090.3

2.6

Nondiscretionary
Items

Tax Transfers to Local Governments

12,883.1

-18.8

14,016.3

8.8

Other Transfers to Local
Governments

639.9

n.a.

914.0

42.8

Debt Service

19,831.9

14.9

21,965.3

10.8

aaa Subtotal

33,354.9

0.7

36,895.6

10.6

Funds to Settle FY 1997 Deficit

1,617.4

n.a.

0.0

-100.0

Total

81,860.1

5.4

84,987.1

3.8

Source: Ministry of Finance

Total public works outlays are unchanged from FY 1999's record
level of just more than ¥9.9 trillion ($90 billion), a figure
that includes a ¥500 billion ($4.5 billion) fund for
Millennium Projects. This special kitty is former Prime Minister
Keizo Obuchi's answer to criticism that traditional public works
endeavors do not help move Japan forward. Millennium Project funds
will be awarded to ministries and agencies on an open, competitive
basis in three areas: improving the country's distribution system,
building advanced communications systems, and developing and
implementing cutting-edge technologies. Although the special fund
represents only 5 percent of total public works outlays, the idea
is sound and is a start at changing the hidebound system.

Social welfare programs will benefit from a 4.1 percent hike
to ¥16.8 trillion ($152.7 billion), with the rise covering
the inauguration of Tokyo's home nursing-care plan and assistance
for families with young children. The ruling Liberal Democratic
Party and its legislative allies, the New Komeito and the New
Conservative Party (see JEI Report
No. 15B, April 14, 2000) have been arguing over how
to distribute the burden of paying for the new nursing-care
program. One faction says that the government should bear most of
the cost; others insist that users pay for the benefit.

Education and science outlays will
increase 0.9 percent to just over ¥6.5 trillion ($59.1
billion). The Ministry of Education plans to put at least one
personal computer in every classroom and to wire every school for
Internet access over the next few fiscal years. Also on MOE's
agenda is an upcoming reform of the higher education
system,1 which likely will require money
for new facilities and training.

Programs to help small companies cope with the changing
economy will see their funding grow by 1 percent to ¥194.3
billion ($1.8 billion). Small businesses also will get targeted
tax breaks for investing in high technology equipment and
training.

Almost ¥6 trillion ($54.5 billion) is allocated for
administrative costs, an extraordinary jump of 11.3 percent. The
money will pay for the scheduled January 1, 2001
reorganization of the central government bureaucracy (see
JEI Report
No. 27B, July 16, 1999) as well as a modest salary
increase for civil servants.

Local governments will see their
ordinary revenue-sharing transfers rise 8.8 percent to ¥14
trillion ($127.3 billion), and will receive a special transfer
worth ¥914 billion ($8.3 billion). Many subnational units are
teetering on the edge of insolvency, according to the Ministry of
Home Affairs. In FY 1998, for example, the ministry reported that
all 47 prefectural governments had ended the year in the red,
including such major metropolitan areas as Tokyo and
Osaka.2 The number of municipalities
operating at a loss more than doubled from the year before,
according to MHA, and other indicators of local fiscal health sank
to new lows. Since local governments actually accept bids and sign
contracts for public works projects, their financial well-being is
critical to Tokyo.

The government's already huge debt-service costs are projected
to climb another 10.8 percent to nearly ¥22 trillion ($200
billion) in FY 2000. Part of this boost is attributable to Tokyo's
plans to increase its reserve for failed banks by ¥4.5
trillion ($40.9 billion). As the government's outstanding debt
reaches Herculean proportions, interest payments are expected to
hit ¥10.7 trillion ($97.3 billion).

Funding for official development
assistance, which is broader than the economic cooperation
category shown in Appendix
Table 3, will ease by 0.2 percent to ¥984.2 billion
($8.9 billion). While money for foreign aid will be tighter
overall, certain high-priority initiatives have been given the
thumbs up, including extra funding for environmental protection
projects and social development (¥12 billion or $109.1
million), clean-energy projects (¥1.8 billion or $16.4
million), child-welfare programs (¥800 million or $7.3
million), nongovernmental organizations in war-torn countries
(¥500 million or $4.5 million), land-mine clearing (¥2.7
billion or $24.5 million), and afforestation (¥400 million or
$3.3 million). Ministry of Foreign Affairs officials are betting
that the slight drop in total ODA money will be more than offset
by the yen's 14 percent appreciation against the dollar since the
initial budget for FY 2000 was compiled. MOFA spokespersons add
that in the coming fiscal year. the ministry will focus on
boosting the efficiency of Japan's foreign aid program and on
funneling more money into humanitarian
aid.3

Defense spending will edge up 0.1 percent to just over
¥4.9 trillion ($44.5 billion), after taking cuts in both FY
1998 and FY 1999. Personnel-related costs are projected to rise by
¥36 billion ($327.3 million) to more than ¥2.2 trillion
($20 billion), due mainly to an expected surge in retirements.
Outlays to implement the decisions of the U.S.-Japan Special
Action Committee on Okinawa will surpass ¥14 billion ($127.3
million), a gain of 15.6 percent. One controversial move is a 2.8
percent slash in host-nation support to ¥260.3 billion ($2.4
billion) as a result of Tokyo's cancellation of several
base-improvement projects. Washington has resisted the reduction
in Japan's financing for U.S. forces based on Japanese soil (see
JEI Report No. 12B,
March 24, 2000). On the plus side, the Obuchi cabinet
added ¥2 billion ($18.2 million) to the FY 2000 budget as
Japan's share of the cost of developing a theater missile defense
system with the United States.

On the downside, food control programs will suffer a 16.7 percent
cut to ¥223.9 billion ($2 billion) under the initial FY 2000
spending plan, while energy projects face a 2.8 percent drop to
¥635.1 billion ($5.8 billion). Because the number of World War
II veterans and their dependents continues to decline, pension costs
are expected to fall 3.6 percent to just over ¥1.4 trillion
(12.3 billion).

General Account Revenues

Analysts at MOF's Budget Bureau expect tax and
stamp revenues to rise 3.3 percent in FY 2000 as the economic
recovery takes hold (see Table 7). However, they also project
that government borrowing will grow another 5 percent despite the
economic rebound. New issues of construction bonds are supposed to
drop a slight 2 percent to ¥9.2 trillion ($83.6 billion), but
general borrowing will jump by 8.1 percent to nearly ¥23.5
trillion ($213.6 billion), a new high for an initial budget. The
overall increase in the sale of new bonds will bring the FY 2000
initial spending plan's dependence on borrowing to a record 38.4
percent (see Appendix Table 1 and
2).

A closer look at revenues (see
Appendix Table 4) reveals some
interesting assumptions by budget planners. The expected 25.7 percent
gain in personal income taxes withheld from workers' paychecks raises
questions, especially since it appears that this year's shunto
(spring wage negotiations) will yield a record-low average hike of
less than 2 percent (see JEI Report
No. 15B, April 14, 2000) and since corporations plan to
continue downsizing. The 4.6 percent drop in receipts from corporate
income taxes also is something of a puzzle. Many companies are
expecting to return to profitability in FY 2000 and tougher
accounting rules will make it more difficult to avoid taxes. However,
the decline is not beyond reason, given the Japanese tax codes that
allow companies operating in the red to avoid most taxes. Finally,
the 5 percent reduction in consumption tax revenues is in line with
the recent weakness of consumer spending but does not jibe with the
government's rosy expectations of renewed economic growth in FY 2000.

As for tax reforms, the FY 2000 blueprint contains no earthshaking
items. The implementation of revised rules that are less favorable
for new home buyers has been moved from January 1, 2000 to
July 30, 2001. The more restrictive provisions will allow
purchasers to claim tax credits for mortgages for six years, rather
than the current 15, and will offer smaller credits.

Small and midsize enterprises are granted special depreciation
credits for new machinery and investment in research and development.
Entrepreneurial or venture SMEs that meet the requirements of the
so-called Angel Tax Plan also can extend special tax treatment to
investors if the company conducts an initial public offering within a
specified period. Capital gains taxes may be cut as much as 50
percent if all conditions are met.

The scheduled introduction of defined-contribution pension plans
modeled after U.S.-style 401(k) plans (see
JEI Report No. 4B, January 28,
2000) demanded some clarification of the tax code. In most cases,
contributions to the new retirement vehicle will be fully tax
deductible, as long as the premiums do not exceed ceilings based on
employment status. Although the reforms state that the premiums are
subject to the Special Corporate Tax on Pension Funds, this 1 percent
levy has been suspended indefinitely.

Overall, the FY 2000 tax reforms will reduce the government's
expected revenues by ¥147 billion ($1.3 billion) the first year
they are in effect (see Table 8). The net change hides higher
taxes for families with children as well as the scale of corporate
investment incentives.

Table 8: Estimated Value of 2000 Tax Reforms

(in billions of yen)

Private Investment Incentives

¥-347

Other

200

aaa End
Extra Child Allowance

203

aaa Special
Corporate Taxes

14

aaa Other

-17

Total

-147

Source: Ministry of Finance

Fiscal Investment and Loan Program

One traditional budget system scheduled for
major changes is the Fiscal Investment and Loan Program, the
government's second capital budget. In preparation for a complete
overhaul of the FILP in FY 2001,4 the
Finance Ministry had sought an 18.7 percent reduction in spending to
just under ¥43 trillion ($390.9 billion). The FILP approved by
the Diet was only slightly more generous than the MOF proposal (see
Table 9 and Appendix Table 5),
adding up to a 17.4 percent cut to ¥43.7 trillion ($397.3
billion). With increases over the initial FY 1999 budget of 5.1
percent each, welfare and land conservation/disaster programs were
the biggest winners. The only other categories to be blessed with
additional money were agriculture (3.6 percent), roads (2.4 percent)
and education (1 percent). Funding for the remaining eight
categories, including regional development, communications and
economic cooperation, will be pared by as little as 0.8 percent
(small business) to as much as 51.2 percent (industry and
technology).

The 54.2 percent plunge from FY 1999's mark in portfolio
investment funds presages the fundamental FILP reform. This drop
shows that the FILP's role as an investor of trust and pension funds
controlled by the government already has begun to shrink rapidly. By
January 1, 2001, this role will disappear entirely. Control of
the trust and pension funds will be returned to the Ministry of
Health and Welfare and the Ministry of Posts and Telecommunications.
With the population graying rapidly, MHW and MPT have argued for the
freedom to invest these funds where they can earn sufficiently high
returns, an argument that must mean that money lent to the FILP was
not working hard enough.

The postal savings system, which is run by MPT, contributed
¥11.5 trillion ($10.5 billion) to the initial FY 1999 FILP, an
amount buried within the Trust Fund Bureau's overall figure. While
the bureau's employee and national pension funds will continue to
lend money to the FILP in FY 2000, it will be smaller than the year
before. Government-administered or controlled pension plans are
scheduled to provide only ¥2.7 trillion ($24.5 billion) in FY
2000, compared with the ¥4.3 trillion ($39.1 billion) in FY
1999. Other Trust Fund Bureau programs will divert more money to the
FILP in FY 2000 compared with the year before  a projected
¥30.6 trillion ($278.2 billion) versus an initial ¥27.9
trillion ($253.6 billion)  but the gain will not offset the
other two reductions. Overall, the Trust Fund Bureau is expected to
allocate ¥10.4 trillion ($94.5 billion) less to the FILP in FY
2000.

As wrenching as these changes may appear, they are merely the
beginning of the process. The Diet is considering legislation that
would establish the final details of the FILP's reform. If adopted,
the FILP and the many quasi-governmental agencies it funds would be
forced to undergo a rapid transition to a market-based fund-raising
system.

The Focus Edges Toward Taxes

The deficit spending that has characterized Tokyo's budgets for
the last decade has concerned Japanese and foreign observers alike.
The Finance Ministry calculates that by the end of FY 2000, the
central government's outstanding debt will top ¥364 trillion
($3.3 trillion), while local government debt will total ¥283
trillion ($2.6 trillion). Together, central and local authorities
will owe ¥647 trillion ($5.9 trillion), or more than 130 percent
of Japan's GDP5  the highest such
level among Group of Seven industrial nations. Economists are engaged
in a heated debate over the impact of this mountain of debt at the
same time they are weighing Tokyo's options for ensuring stable
growth in the near term. Although politicians and bureaucrats are
loath to utter the T-word publicly during an election year, taxes are
edging toward center stage in the evolving discussions of Japan's
fiscal policy.

In one sense, the Japanese public is ready for this debate since
it is suffering from "fiscal stimulus overload." The idea that the
government can spend its way out of a recession has been discredited
 or at least shown to be an incomplete answer. As a nation of
savers, the Japanese easily can understand the dangers of getting
deeply into debt. Although the options for dealing with creditors
that are available to individuals are significantly different from
those available to sovereign nations, taxpayers understand that if
the government spends freely now, they eventually will get handed the
bill, either in the form of higher taxes or as inflation that erodes
the value of their savings.

Income Taxes

Highly progressive personal income tax rates
have been considered an important part of social as well as economic
development in postwar Japan.6 High marginal
income taxes narrowed the income distribution gap between rich and
poor, allowing most Japanese to believe, with some justification,
that they were solidly in the middle class. A decade of stagnation in
the 1990s is changing this. Just as winners and losers are emerging
among companies, income variation among households is
widening.7

Tokyo has tried cutting income taxes to help boost the economy
several times over the last decade. The issue became a major
political theme in 1994, eventually leading to a two-year, ¥5.5
trillion ($50 billion) reduction. The cut consisted of permanent rate
changes worth ¥3.5 trillion ($31.8 billion) and rebates valued
at ¥1 trillion ($9.1 billion) in each of the two years. The
rebate was extended for a third year, finally expiring in 1997.
Because the economy was performing very poorly and the banking
industry's nonperforming-loan crisis was building, households
cautiously saved their tax windfall instead of spending it.

With the economy still shaky, policymakers
are eyeing plans to lower income taxes again to help spur
consumption. Although the banking industry has put most of its
bad-loan problems behind it, corporate Japan is engaged in a major
downsizing campaign.8 Given such
restructuring coupled with several years of minimal wage hikes, it
would not be surprising if Japanese households again chose to save
any tax windfall instead of going on a shopping spree.

Corporate income taxes also are on the table. While Japanese
executives long have complained that the tax code puts them at a
disadvantage with some of their foreign rivals, overseas firms have
expressed the opposite view. As Tokyo groped for revenue in the
mid-1990s, Japanese corporations had to bear a special levy,
something executives do not want to repeat.

Tokyo metropolitan Gov. Shintaro Ishihara, however, has other
ideas. Faced with plummeting revenues, Mr. Ishihara boldly suggested
a special levy aimed at the country's largest banks that would
replace the local corporate income tax for five years. Moreover, the
3-percent levy would not be based on net profits but on gross
profits, meaning that even firms that suffered net losses would have
to pony up (see JEI Report No. 7B,
February 18, 2000).

Central government authorities were at least as furious with Mr.
Ishihara's proposal as were the executives of targeted banks. After
digging through the law books, the cabinet and the Finance Ministry
had to admit that they could not prevent the Tokyo city government
from levying the tax. The Tokyo metropolitan assembly approved the
plan, which became effective April 1. Banks moved immediately to
stop the tax in court, but the legal prospects of the case are
unclear. In any event, because of the way local corporate income
taxes are calculated and collected, banks will not have to pay the
new tax until June 2001.

Central authorities were angry with Mr. Ishihara  in part
because he beat them to the policy. In response to another major
criticism of the current corporate tax system  that companies
reporting net losses essentially are exempt from paying taxes 
the government had been examining the idea of basing corporate taxes
on some other measure of business activity that included gross sales
and profits. With such a tax now in operation, central authorities
have a test case to evaluate the pros and cons of this approach.

Consumption Tax

Controversial from the moment it was first imposed in FY 1989, the
national and local consumption levy continues to be a flash point in
the reform debate. Many tax experts long have warned that the
government's reliance on direct taxes would become untenable as the
country's demographics changed to a population heavily weighted with
senior citizens. Thus, the original rationale for the consumption tax
was to reduce dependence on personal income taxes in a very gradual
fashion.

After some initial grumbling and effort to work through compliance
issues, the nation's businesses and consumers grudgingly, but not
quietly, accepted the levy. Observers say that the new tax's
unpopularity helped evict the Liberal Democratic Party from control
of the government in 1993. The tax played a similar role in 1998 and
was a factor in the resignation of Prime Minister Ryutaro Hashimoto
(see JEI Report
No. 27B, July 17, 1998). Voters were unhappy when the
tax was boosted by 2 percentage points in 1997, snuffing out a
nascent economic recovery.

Fiscal experts say that despite this
checkered past, further increases in the consumption tax are
inevitable, given Japan's changing demographic and economic
situation. One analyst has estimated that the tax would have to be
pushed as high as 12 percent for the next 25 years in order to
balance the budget and begin to pay down the outstanding national
debt.9 Such numbers naturally give pause to
politicians, even those who agree that higher consumption taxes are
vital.

To get over any "sticker shock," some politicians and bureaucrats
have suggested gradually boosting the levy over a period of decades.
In addition, they would build flexibility into the schedule to give
policymakers room to respond to an economic downturn. Another idea is
to earmark consumption tax revenues for social welfare programs,
reasoning that voters would find such a tax more palatable if they
directly benefited from it.

Still another variant that has been proposed is a value-added tax.
One of the attributes of a broad VAT is that its amount usually is
hidden in the price of a product or a service rather than explicitly
added to the final bill. Politicians might see the disguise as a
distinct advantage since consumers would not be reminded of the tax
amount everytime they made a purchase.

Other Taxes

The central government has been stung by critics who claim that in
the 1990s, outdated rules, regulations and bureaucratic practices
prevented the country from adapting more quickly to changing economic
realities, prolonging the stagnation. The government is committed not
only to its administrative restructuring, but also to reviewing such
key laws as the Commercial Code with an eye toward updating them. Tax
codes certainly are getting their share of attention in this revamp,
as shown in several different areas:

Real Estate Taxes - The country's nonperforming-loan
problems can be traced to the precipitous decline in property values
since 1989. One method of disposing of bad loans that was used
successfully in the United States involved bundling together real
estate and other assets pledged as collateral and using them as a
basis for issuing a security. Tokyo tried to emulate this success in
late 1998 by permitting the establishment of special purpose
corporations whose primary function would be to act as intermediaries
in the securitization process. After a year of operation, however,
government and private-sector analysts realized that taxes on land
transactions and other tax issues were blocking the smooth operation
of SPCs. Although in most cases, these payments are refunded
eventually, sellers and buyers are forced to give the tax collector
significant sums of money up front to conclude the securitization
deal. The Finance Ministry has been trying to get legislation passed
that would make the process more flexible. However, the Home Affairs
Ministry is resisting because the proposed changes would further hurt
the finances of local governments, which actually collect the money.

"Green" Taxes - Japan's growing environmental consciousness
has generated a spirited debate on several taxes with a "green" tint.
To promote energy conservation, for example, the Ministry of
International Trade and Industry wants to fatten the tax breaks given
to buyers of electric or low-emissions vehicles. The Finance
Ministry, on the other hand, wants to reduce the advantage because it
feels that even drivers of clean vehicles should bear a fair share of
the cost of building and maintaining roads.

Imposing a tax on companies whose activities
emit large amounts of carbon dioxide and other so-called greenhouse
gases is another flash point. Under the 1997 Kyoto Protocol, Japan is
committed to cutting its output of greenhouse gases by 6 percent at
some point between 2008 and 2012.10
Environmental activists argue that taxes on polluting activities
would provide a very strong incentive for offenders to reform. Many
executives, however, counter that imposing a potentially heavy tax at
a time when companies are struggling to stay in business is not good
policy.

Tobacco Tax - While the anti-smoking forces recently have
scored some successes against tobacco companies in the United States,
the movement is just beginning in Japan. Since the government retains
a controlling share of Japan Tobacco Inc. and JT still has a legal
monopoly on producing cigarettes in Japan, official resistance to
anti-smoking campaigns is understandable. Powerful advocates for
change do exist, however. Shizuka Kamei, a chief LDP policymaker,
proposed in January that the tax on tobacco products be increased as
part of the FY 2000 tax bill. His recommendation was snuffed out
quickly by his LDP colleagues and JT officials. Given the Clinton
administration's success at fattening revenues and deterring smokers
by jacking up the federal cigarette tax, however, Mr. Kamei's idea is
likely to resurface in the future.

The Long-Term View

Japanese politicians and bureaucrats clearly have no lack of
short-term fiscal issues to debate. At the same time, they generally
agree that long-range issues need to be tackled.

Budget Process Reform - As Mr. Obuchi's Millennium Projects
concept shows, some movement toward addressing long-standing
complaints about the budget process has occurred. The Finance
Ministry's iron grip on the system has distorted the thrust of fiscal
policy, according to some critics, bending it from serving the
nation's needs to accommodating those of the bureaucracy. Because
bureaucratic politics play such a large role in the process,
decisions are not always made on the basis of merit. Critics point
out, for example, that public works funds are handed out to the
Ministries of Construction, Transport, and Education and Welfare
according to an unchanging formula because it smooths the process.
Each gets its customary share, but the money may not be allocated
optimally from society's standpoint.

The most recent serious attempt to revamp
the budget process was the Fiscal Structural Reform Act of
1997.11 The law set out both general and
specific goals, including:

Cutting the combined central and local government budget
deficit to 3 percent or less of GDP by FY 2003.

Ending new issues of general revenue bonds by FY 2003.

Restructuring the Fiscal Investment and Loan Program.

Setting caps through FY 2000 for spending categories
previously considered sacred, for example, defense and official
development assistance.

Cutting FY 1998's public works budget by at least 7 percent
from the FY 1997 level.

These admirable goals were torpedoed, however, by the long-running
recession. The law has been in temporary suspension since FY 1998 to
give the government more flexibility to get the economy moving. The
law may eventually have its full intended impact, but that day is a
way off.

FILP Reform - One goal of the 1997
Structural Reform Act appears to be nearing realization:
restructuring the FILP. If, as expected, the Diet approves the
pending reform legislation, the process could be initiated as early
as January 2001. Because the FILP funds so many quasi-governmental
agencies  for example, regional development agencies, the
Housing Loan Corp., the Small Business Finance Corp., the Japan
Highway Public Corp. and the Pension Welfare Service Public Corp.
 that play important roles in the economy, fundamental changes
in the program will have wide-ranging effects. Experts agree that it
could take decades to complete the transition and that the costs
could be far higher than Tokyo is willing to admit. The Finance
Ministry recently warned that it would take ¥5 trillion ($45.5
billion) just to pay off the current debts of the operations funded
by the FILP; private-sector analysts say that the true price tag is
several times this amount.12

Funding Social Welfare Programs - The Japanese have enjoyed
state-funded drug prescription and other social welfare programs and
now can apply for home nursing-care assistance. Policymakers are
debating whether the government can afford to continue this largess.
The negotiations between the LDP and its coalition allies over the
¥4.3 trillion ($39.1 billion) home-care program illustrate the
point. The LDP and the New Komeito proposed collecting insurance
premiums from everyone aged 40 and older. The Liberal Party  a
part of which remains in the ruling coalition as the New Conservative
Party  countered with the idea that consumption tax revenues be
used to cover not only the new program but also the existing basic
national pension system and any other medical services for the
elderly as well. A wide range of social factors were brought into the
debate, but the issue really boils down to who is going to pay.

Such knotty problems will keep politicians busy for years.
Clearly, however, fiscal stimulus will not be employed in the
immediate future as heartily as it was in the past decade. Rising
concerns about the national debt leave little room for maneuver. But
removing fiscal stimulus from the government's arsenal of economic
tools would be unrealistic and short-sighted. The consensus, however,
is that the sooner Tokyo begins to take action on the long-term
problem of the mounting national debt, the easier it will be to
resolve. Suddenly turning off the steady stream of fiscal stimulus
that began in the early 1990s might be traumatic in the short term,
but slowing it gradually will take political will, something that may
be in short supply in an election year.

The views expressed in this report are those of the
author
and do not necessarily represent those of the Japan Economic
Institute